Beat Brexit by diversifying internationally

"It looks likely that in future this element will be fixed in money terms and no longer inflation linked, so we may need to take a small income from our investments," says Hugh. "Our home, which I think is worth about £500,000, is mortgage free.

"While my health is good at the moment, my life expectancy is probably 10 to 15 years, the time scale over which it is predicted that Brexit will be a drag on our economy. I have long been concerned at the direction of the UK economy with low productivity, unsustainable levels of private and public debt, and a serious balance of payments problem. To that mix has now been added the uncertainty of Brexit which most economists see as damaging to the UK's short-term economic prospects, even if some see potential benefits further out.

"For many years, I have enjoyed managing my own investments focusing on individual shares in an economy that I know - the UK. I try to avoid collective investments where possible and I am drawn towards younger, smaller growing companies.

"Now, however, it seems that I need to think again and perhaps restructure for the next decade or two. So what 10-year strategy could I adopt and where do I invest - Europe, Asia Pacific, the US or Latin America? Also what type of asset will best protect our family wealth against what I view as, at best economic stagnation in the UK, or quite possibly an economic crisis? Land, houses, gold or shares?

"Or am I being too gloomy and should I stay put?"

Hugh's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You ask how we should invest to protect ourselves from economic stagnation and the threat of a crisis. In one sense, the answer's very simple.

On a 10-year view, you can guarantee real returns simply by holding a 10-year index-linked bond. You could accompany this with foreign currency, because sterling usually falls in the event of a crisis. And you might add other bonds, because stagnation or a crisis would further reduce yields thus giving you a capital gain on these.

And we might add gold too. This isn't so much because it protects us from inflation - index-linked bonds do that better - but because it too is a play upon interest rates: the lower these go, the higher the gold price should be.

But there's one problem with such a strategy: it will lose you money. Real yields on 10-year index-linked bonds are minus 2 per cent, and prospective real returns on cash are also negative.

This tells us that many investors share your pessimism. They want to buy insurance against stagnation, and when demand for insurance is high, its price is high and expected returns are low.

If you want a decent chance of good returns you must therefore hold some equities. If we avoid a crisis and if stagnation doesn't intensify, these should at least outperform bonds.

But which ones? I'd warn you against a preference for younger, smaller, growing companies. Even in good times, growth stocks are often over-priced. They are likely to be more so in bad times. The same lack of investment and innovation that gives us stagnation at the macro level also gives us few growth stocks at the micro level. And weak growth is likely to depress sentiment, which is especially bad for newer and smaller stocks. And needless to say, in a full-blown crisis they would do especially badly.

James Norrington, specialist writer at Investors Chronicle, says:

With so much uncertainty in the world, it is easy to become unsettled and worry about where to invest but before you ask yourself questions relating to portfolio management, it is important to first take a step back and give yourself a wealth planning appraisal. In your case, there is plenty to be pleased about: a mortgage-free home, good health and a pension income of £50,000 a year that should cover regular expenses.

Although the British Steel scheme faces uncertainty, as over £20,000 a year of your pension income comes from other sources you should still be able to live comfortably - especially if you take a supplementary income from your equity portfolio. With a large cash reserve and your National Savings & Investments (NS&I) to boot, you are in a far stronger position than most to ride out any future crises.

Your relative financial security affords both time and the capacity to accept risk in the equity portfolio. This is fortunate because in the current investment environment you could easily be very disappointed by the results of wholesale changes. Therefore, before you start incurring dealing costs think about what you are looking to achieve. Given your circumstances, there is little need to sell out of holdings to release capital, although there could be the need to generate further income to top up your pension.

The problem with bond yields being on the floor is everyone wants income stocks, so they are expensive. Here your capacity to be patient is an advantage. Highlight some of the reliable dividend payers that you already own and when there are dips in the stock market, top up your holdings. It is important to watch that you don't become over concentrated in one stock or sector, so keep an eye on this. Also monitor the level of dividend cover - to what extent the pay-out is covered by profits - and the quality of earnings such as the portion of profits generated from operating cash flow.

Matthew Phillips, managing director at Thomas Miller Investment, says:

You need to think about the future, although your life expectancy estimate seems about right. Practically what would happen to the portfolio if you were not able to continue to manage it on a day-to-day basis? This is a large portfolio and this is a consideration as you approach later life. While you understand the risk you are taking do the members of your family, who would need to manage it if you became incapacitated, also understand this?

Your portfolio does not seem to reflect a coherent investment strategy. This is not unusual in portfolios that have been built up over time and now it needs to be addressed. The portfolio needs to be more diversified to be in the best position to weather whatever storms may come. It is too heavily focused on UK equities and has too many holdings.

We generally suggest that you start reducing investment risk in later life.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I'd suggest two things. One is something you are already doing - holding defensives. We know these tend to outperform over the long run. There's not much reason to suppose this would change in an era of stagnation - it hasn't so far.

Another thing you can do is overcome your aversion to collective investments such as funds, investment trusts and exchange traded funds (ETFs), as these can help you diversify internationally. Doing this would help protect you from a UK slowdown. And investing in emerging markets might help mitigate the danger of secular stagnation in the west, because such countries are perhaps for now less vulnerable to the problems of ageing populations and a lack of profitable investment opportunities.

This, though, isn't a panacea. Most international markets are correlated with each other, especially in bad times, so your ability to spread risk is limited. One possible exception to this might be Frontier Markets which are less well integrated into the world economy, hence slightly less correlated with the UK. However, you pay a price for these in terms of lower liquidity.

But there's a question here: do you really need to buy and hold for 10 years? I suspect that a slightly more activist strategy might work - following the 10-month rule when buying and selling.

It's possible that stagnation will generate bubbles, as low interest rates cause investors to reach for yield. Buying when share prices are above their 10-month or 200-day average allows you to ride these bubbles. And if the bubbles deflate slowly, selling when prices are below average gets you out before the full losses are suffered.

We know that such a rule has worked in a stagnant market, because investors who used it in Japan avoided most of its post-1989 bear market.

James Norrington says:

There are a lot of holdings in this portfolio which could do with pruning to free up capital. This should be a gradual process and one on which you may be best off getting professional advice. When markets are expensive you should be looking to sell out of some stocks where you think the investment case is weakest.

This will in part be a qualitative exercise but you could ask an adviser to help with more quantitative analysis. For example, which smaller stocks would they classify as having growth or value driven performance, and which of these styles could have further to run? The stocks you are least happy with could be sold to fund the purchase of income-generating stocks when these become cheaper.

You concede that the portfolio is very UK-centric which means that you aren't diversifying away the particular risks of UK-listed investments. However, in spite of your aversion to collective investment schemes, you have begun to make use of investment trusts and ETFs to gain some international exposure. The last financial crisis highlighted growing correlations between global equity markets, so this is no guarantee of nullifying all the risk of your UK stocks. Over time though, the international diversification is a worthwhile exercise that will give you the opportunity to profit from other advanced economies that may have different cyclical strengths, and developing regions that are forecast to grow fastest.

In the meantime, as you build up internationally-focused holdings, some of the larger companies in your portfolio are giving you exposure to overseas economies. In particular, the big dollar earners are benefiting from sterling's weakness, so your investments already afford a degree of protection against Brexit uncertainty.

Overall, you are in a strong position and there is no need to panic and make too many changes at once.

Matthew Phillips says:

Of the 40 holdings that are directly in UK stocks many are small, and I would therefore question their inclusion or what difference they are going to make to the portfolio.

A portfolio with a 10-year time horizon could have a much broader international diversification and, dependent upon risk appetite, still afford to be biased towards equities. On such a time horizon, Asia Pacific ex Japan, global emerging markets and Europe all look good value. If Brexit continues to cause concern, and sterling remains at these levels or falls further, then the UK is not a bad place to invest - just not to the extent you currently are.

Alternative areas such as infrastructure could be considered, and given the uncertain backdrop adding bit of gold via a physical ETF that accounts for a small portion of the portfolio could be a good idea.

Use of collective investments would enable the greater diversification required, produce a more focused and diverse approach in different markets and asset classes, and simplify the portfolio.

We understand that they may not be as exciting as investing directly in shares, however, the use of passive funds and ETFs can keep costs down. We also think, particularly at your time of life, that portfolios probably need to be structured and 'boring.'